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Chapter Eighteen. Externalities, Open Access, and Public Goods

1.

Chapter
Eighteen
Externalities,
Open Access,
and Public Goods

Externalities, Open Access, and Public
Goods
• In this chapter, we examine six main
topics
– Externalities
– The inefficiency of competition with
externalities
– Market structure and externalities
– Allocating property rights to reduce
externalities
– Open-access common property
– Public goods
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3.

Externalities
• Externality
– The direct effect of the actions of a
person or firm on another person’s wellbeing or a firm’s production capability
rather than an indirect effect through
changes in prices.
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4.

Externalities
• Externalities may either help or harm
others.
• An externality that harms someone is
called a negative externality.
• A positive externality benefits others.
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5.

The inefficiency of competition with
externalities
• Competitive firms and consumers do
not have to pay for the harms of their
negative externalities, so they create
excessive amounts.
• Because producers are not
compensated for the benefits of a
positive externality, too little of such
externalities is produced.
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6.

The inefficiency of competition with
externalities
• Private cost
– The cost of production only, not
including externalities
• Social cost
– The private cost plus the cost of the
harms from externalities
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7.

Supply-and-Demand Analysis
• We use a supply-and-demand diagram
to illustrate that a competitive market
produces excessive pollution because
the firms’ private cost is less than their
social cost.
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8.

Figure 18.1 Welfare Effects of
Pollution in a Competitive Market
• The competitive equilibrium, ec , is
determined by the intersection of the
demand curve and the competitive
supply or private marginal cost
curve, MC p , which ignores the cost of
pollution.
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9.

Figure 18.1 Welfare Effects of
Pollution in a Competitive Market
• The social optimum, es , is at the
intersection of the demand curve and
the social marginal cost curve,
MC s MC p MC g , where MC g is the
marginal cost of the pollution (gunk).
Private producer surplus is based on
curve, and social producer surplus is
s
MC
based on the
curve.
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10.

Figure 18.1 Welfare Effects of
Pollution in a Competitive Market
450
MC s = MC p + MC g
A
MC p
es
ps = 282
B
C D
H
pc = 240
198
F
84
E
G
ec
MC p
MC g
MC g
30
Demand
0
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Qs = 84 Qc = 105
225
Q, Tons of paper per day
18–10

11.

Supply-and-Demand Analysis
• The figure illustrates two main results
with respect to negative externalities.
• First, a competitive market produces
excessive negative externalities.
• Second, the optimal amount of pollution
is greater than zero.
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12.

Reducing Externalities
• Because competitive markets produce
too many negative externalities,
government intervention may provide a
social gain.
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13.

Table 18.1 Industrial CO2 Emissions,
2002
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18–13

14.

Reducing Externalities
• If a government has sufficient
knowledge about pollution damage, the
demand curve, costs, and the
production technology, it can force a
competitive market to produce the
social optimum.
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15.

Reducing Externalities
• A governmental limit on the amount of
air or water pollution that may be
released is called an emission standard.
A tax on air pollution is called an
emissions fee, and a tax on discharges
into the air or waterways is an effluent
charge.
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16.

Reducing Externalities
• Internalize the externality
– To bear the cost of the harm that one
inflicts on others (or to capture the
benefit that one provides to others)
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17.

Figure 18.2 Taxes to Control
Pollution
• Placing a tax on the firms equal to the
g
harm the gunk, t (Q) MC , causes
them to internalize the externality, so
their private marginal cost is the same
s
as the social marginal cost, MC . As a
result, the competitive after-tax
equilibrium is the same as the social
optimum, es .
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18.

Figure 18.2 Taxes to Control
Pollution
• Alternatively, applying a specific tax of
$84 per ton of paper, which is the
marginal harm from the gunk at Qs 84 ,
also results in the social optimum.
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19.

Figure 18.2 Taxes to Control
Pollution
450
MC s = MC p + t (Q)
MC p +
es
ps = 282
MC p
= 84
MC p
= 198
MC g
MC g = 84
Demand
0
Qs = 84
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225
Q, Tons of paper per day
18–19

20.

Cost-Benefit Analysis
• By using a cost-benefit analysis, we
obtain another interpretation of the
pollution problem in terms of the
marginal cost and benefit of the
pollution itself.
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21.

Cost-Benefit Analysis
• Welfare is maximized by reducing
output and pollution until the marginal
benefit from less pollution equals the
marginal cost of less output.
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22.

Figure 18.3 Cost-Benefit Analysis
of Pollution
a) The benefit curve reflects the reduction in
harm from pollution as the amount of gunk
falls from the competitive level. The cost of
reducing the amount of gunk is the fall in
output, which reduces consumer surplus
and private producer surplus. Welfare is
maximized at 84 tons of paper and 84 units
of gunk, the quantities at which the
difference between the benefit and cost
curves, the net benefit, is greatest.
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23.

Figure 18.3 Cost-Benefit Analysis
of Pollution
b) The net benefit is maximized where
the marginal benefit, MB , which is the
slope of the benefit curve, equals the
marginal cost, MC , the slope of the
cost curve.
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24.

Figure 18.3
Cost-Benefit
Analysis
of Pollution
(a) Cost and Benefit
Cost: less paper
4,000
Benefit: less gunk
2,000
0
105
Maximum
net
benefit
84
63
(b) Marginal Cost and Marginal Benefit
Q, Tons of paper per day
G, Units of gunk per day
MC
105
84
MB
0
105
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84
Q, Tons of paper per day
G, Units of gunk per day
18–24

25.

Market Structure and Externalities
• Two of our main results concerning
competitive markets and negative
externalities—that too much pollution is
produced and that a tax equal to the
marginal social cost of the externality
solves the problem—do not hold for
other market structures.
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26.

Monopoly and Externalities
• Although the competitive market with an
externality always produces more
output than the social optimum, a
monopoly may produce more than, the
same as, or less than the social
optimum.
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27.

Monopoly and Externalities
• Which effect dominates depends on the
elasticity of demand for the output and
on the extent of the marginal damage
the pollution causes.
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28.

Monopoly Versus Competitive Welfare
with Externalities
• In the absence of externalities, welfare
is greater under competition than under
an unregulated monopoly.
• However, with an externality, welfare
may be greater with monopoly than with
competition.
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29.

Figure 18.4 Monopoly, Competition,
and Social Optimum with Pollution
• At the competitive equilibrium, ec , more
is produced than at the social
optimum, es . As a result, the deadweight
loss in the competitive market is D . The
monopoly equilibrium, em , is determined
by the intersection of the marginal
revenue and the private marginal
p
cost, MC , curves.
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30.

Figure 18.4 Monopoly, Competition,
and Social Optimum with Pollution
• The social welfare (based on the
s
marginal social cost, MC , curve) under
monopoly is A B. Here the deadweight
loss of monopoly, C , is less than the
deadweight loss under competition, D .
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31.

Figure 18.4 Monopoly, Competition,
and Social Optimum with Pollution
450
MC s = MC p + MC g
et
330
310
282
em
es
A
B
MC p
D
C
ec
240
MC g
30
MR
0
60 70
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84
105
Demand
225
Q, Tons of paper per day
18–31

32.

Taxing Externalities in Noncompetitive
Markets
• Trying to solve a negative externality
problem is more complex in a
noncompetitive market than in a
competitive market.
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33.

Taxing Externalities in Noncompetitive
Markets
• To achieve a social optimum in a
competitive market, the government
only has to reduce the externality,
possibly by decreasing output.
• In a noncompetitive market, the
government must eliminate problems
arising from both externalities and the
exercise of market power.
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34.

Allocating Property Rights to Reduce
Externalities
• Instead of controlling externalities
directly through emissions fees and
emissions standards, the government
may take an indirect approach by
assigning a property right: an
exclusive privilege to use an asset.
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35.

Allocating Property Rights to Reduce
Externalities
• If no one holds a property right for a
good or a bad, the good or bad is
unlikely to have a price.
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36.

Allocating Property Rights to Reduce
Externalities
• For many bads, such as pollution, and
for some goods, property rights are not
clearly defined. No one has exclusive
property rights to the sir we breathe.
Because of this lack of a price, a
polluter’s private marginal cost of
production is less than the full social
marginal cost.
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37.

Coase Theorem
• According to the Coase Theorem
(Coase, 1960), the optimal levels of
pollution and output can result from
bargaining between polluters and their
victims if property rights are clearly
defined.
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38.

39.

40.

Coase Theorem
If there are no impediments to
bargaining, assigning property rights
results in the efficient outcome at which
joint profits are maximized.
Efficiency is achieved regardless of who
receives the property rights.
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41.

Coase Theorem
Who gets the property rights affects the
income distribution. The property rights
are valuable. The party with the
property rights may be compensated by
the other party.
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42.

Problems with the Coase Approach
• First, if transaction costs are very high,
it might not pay for the two sides to
meet.
• Second, if firms engage in strategic
bargaining behavior, an agreement may
not be reached.
• Third, if either side lacks information
about the costs or benefits or reducing
pollution, a nonefficient outcome may
occur.
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43.

Markets for Pollution
• If high transaction costs preclude
bargaining, we may be able to
overcome this problem by using a
market, which facilitates exchanges
between individuals.
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44.

Markets for Pollution
• Under this cap and trade system, the
government gives firms permits, each of
which confers the right to create a
certain amount of pollution. Each firm
may use its permits or sell them to other
firms.
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45.

Markets for Pollution
• Bu using a market, the government
does not have to collect this type of
detailed information to achieve
efficiency. Its only decision concerns
what total amount of pollution to allow.
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46.

47.

Overuse of Open-Access Common
Property
Because people do not have to pay to
use open-access common property
resources, they are overused.
e.g. 1. Common Pools.
2. The Internet.
3. Roads
4. Fisheries.
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48.

Solving the Commons Problem
• Government Regulation of Commons
– Overuse of a common resource occurs
because individuals do not bear the full
social cost. However, by applying a tax
or fee equal to the externality harm that
each individual imposes on others, a
government forces each person to
internalize the externality.
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49.

Solving the Commons Problem
• Government Regulation of Commons
– Alternatively, the government can
restrict access to the commons. One
typical approach is to grant access on a
first-come, first-served basis.
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50.

Solving the Commons Problem
• Assigning Property Rights
– An alternative approach to resolving the
commons problem is to assign private
property rights.
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51.

52.

53.

Markets for Public Goods
• Markets for public goods exist only if
nonpurchasers can be excluded from
consuming them.
• Markets do not exist for nonexclusive
public goods.
• If the government does not provide a
nonexclusive public good, no one
provides it.
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54.

Demand for Public Goods
• Because a public good lacks rivalry,
many people can get pleasure from the
same unit of output. As a consequence,
the social demand curve or willingnessto-pay curve for a public good is the
vertical sum of the demand curves of
each individual.
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55.

Figure 18.5 Inadequate Provision of
a Public Good
• Security guards protect both tenants of
the mall. If each guard costs $10 per
hour, the television store, with
demand D1, is willing to hire four guards
per hour. The ice-cream parlor, with
2
D
demand , is not willing to hire any
guards.
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56.

Figure 18.5 Inadequate Provision of
a Public Good
• Thus if everyone acts independently,
the equilibrium is e p . The social
demand for this public good is the
vertical sum of the individual demand
curves, D . Thus the social optimum is es,
at which five guards are hired.
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57.

58.

Free Riding
• Many people are unwilling to pay for
their share of a public good. They try to
get others to pay for it, so they can free
ride: benefit from the actions of others
without paying.
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59.

60.

Free Riding
• In each of these games, the Nash
equilibrium is for neither store to hire a
guard because of free riding. The
nonoptimal outcome occurs for the
same reason as in other prisoners’
dilemma games: The stores don’t do
what is best for them collectively when
they act independently.
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61.

Reducing Free Riding
• Governmental or other collective actions
can reduce free riding.
• Methods that may be used include
social pressure, merges, compulsion,
and privatization.
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62.

Valuing Public Goods
• To ensure that a nonexclusive public
good is provided, a government usually
produces it or compels others to do so.
Issues that a government faces in
providing such a public good include
whether to provide it at all and, if so,
how much to provide.
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63.

64.

Valuing Public Goods
• The problem with yes-no votes is that
they ignore the intensity of preferences.
• Thus such majority voting fails to value
the public good fully and hence does
not guarantee that it is efficiently
provided.
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